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Insurance companies have the perfect 'heads I win, tails you lose' game in the fixed annuity business. It's very profitable, and few consumers understand the how the rules are stacked against them.

First, a quick review about annuities. They come in two general flavors, variable and fixed. Variable annuities are merely an insurance company wrapper around a pooled investment account similar to a mutual fund. The return is entirely dependent on the earnings of the underlying investment pool.

The fixed annuity is somewhat like buying a CD. The insurance company declares a rate that they will pay, and the investments are a general obligation of the company. The company invests the funds in one or more bond portfolios, but the return is only loosely related to the performance of the bonds. The actual return to the investor may be more or less than the performance of the underlying portfolio, especially in the short term.

Both variable and fixed annuities are usually sold as general investment vehicles with tax deferral until the funds are withdrawn. Under current tax law, this tax deferral is of very limited value.

The contract holder always has the right to convert his account into a lifetime income (annuitize the contact). However, in real life, few actually do. So we will confine our discussion of the deferred annuity.

Let’s agree on a few simple concepts:

-Insurance companies cannot long pay out more than they earn on the underlying bond portfolio.

-Insurance companies have no particular edge in the bond market. Indeed, the overwhelming evidence indicates that they are just as inept as other active managers when trading their bond portfolios.

-Because the business is highly profitable, and the product difficult to sell, insurance companies pay obscenely high commissions. These commissions are just the right incentive for highly motivated product salesmen, but may not lead to appropriate recommendations for consumers. It’s not an accident that objective, fee-only advisors hardly ever recommend annuities, while commissioned sales people seem to love them.

-Commissions, administrative costs, and insurance company profit all reduce the net income which the insurance company can pay out to the policy owner. In plain English, this means that the return to the investor must be considerably less than the insurance company earns on the bonds, which in turn is usually less than the market rate.

With that in mind, how do insurance companies actually sell this stuff, and what is likely to happen post sale to the consumer?

To lure consumers, insurance companies generally offer initial interest rates that are above market for a limited period of time, typically one year. These initial rates are often represented and illustrated as what the consumer can expect over the life of the contract. High projected rates sell contracts. And, after all, they are only estimates.

Once the initial guarantee expires, the contract begins to pay out the “current credited” rate. This current credited rate is whatever the insurance company decides to pay, limited only by a “guaranteed” rate contained in the contract. As we will see later, this rate may not be set exclusively with the client’s best interest at heart.

Very few insurance companies pay the same credited rates to all annuity holders. Most segregate the contracts into groups by purchase date, and invest the funds for each group in a separate pool of bonds. As a result, getting a clear picture of what an insurance company’s credited rates are is far more complex than it might appear to be.

If the contract owner is unhappy with the current rate, he typically is faced with stiff surrender charges which deter him from withdrawing funds from the contract or switching to another insurance company offering higher rates. Surrender charges can lock the consumer into the contract for quite some time, often running for seven to ten years. The annuity contract looks a lot like the roach motel, once you are in, you don’t get out.

Surrender costs exist, among other reasons, to insure that the insurance company has the money long enough to repay themselves for the outlandish commission they paid the agent to acquire the contract. Between the expiration of the initial rate and the end of the surrender charge period the consumer is at the tender mercy of the insurance company. Long personal experience has convinced me that this is not necessarily a good place to be.

Let’s look at how this might play out based on my observations over a long career.

Scenario 1: Today, interest rates are low throughout the economy. You check CD rates with all your local banks only to find that the best rate available is 2%. So, when an eager young man offers you an annuity with a 6% rate, it looks pretty good. Somewhere in the conversation there is a strong implication that you can count on that 6% forever. But let’s suppose that a year later interest rates in the economy have gone up to 7%. You are shocked to find that your credited rate has dropped to 4%, just barely above the minimum contract guarantee rate of 3%, but still far short of the rates the bank is offering. Faced with a 10% surrender fee, you grumble and cave in.

The insurance company’s problem is that the long duration bond portfolio purchased for you is now greatly reduced in value due to the higher interest rates. Few companies will refinance because they have locked in favorable rates with their bonds. So, the insurance company is faced with capital losses in the account and very little chance to roll the bonds for higher returns.

Wait. It gets worse. New contracts are being offered to new purchasers at an 8% rate. However, you are stuck with a rate of only half that amount. The new contracts are invested in a new pool of bonds at considerably higher coupon rates. Of course, the insurance company could “blend” the credited rates, but the marketing department would never stand for that. If they can’t offer new purchasers a higher rate than the banks and other insurance companies they won’t get any new business. So in this case the interests of existing contract holders are sacrificed so that the company can attract new business.